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Guided lessons on markets, signals, and the TickerVue terminal.
TickerVueGuided lessons on markets, signals, and the TickerVue terminal.
Guided lessons on markets, signals, and the TickerVue terminal.
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Finance can be thought of through one central concept: opportunity cost. Most choices, with money and in life, can be understood as the benefit of one option compared with the next best alternative. Money is useful because it is a fungible, exchangeable unit of choice. I do work now, receive currency, and can later exchange that currency for someone else's work. In that sense, finance is largely about reducing friction in how we store, transfer, and allocate those units of choice.
It is easy to lose sight of this. People may feel they have already made the best choice they reasonably can with their money, and there are understandable reasons for that. Even professional hedge funds, on average, do not beat the S&P 500. So why should an individual expect to do better than teams of quants?
But it is worth thinking about the opportunity cost of accepting that logic too quickly. You might work 40 hours a week, 2,000 hours a year, and earn a meaningful amount of money, then spend almost no time deciding what that money should do next. Maybe it goes into an S&P 500 ETF because that feels like the obvious answer. Maybe it sits in a savings account earning far less than the bank earns on it. These are understandable defaults, but they are not free. The cost is just hidden.
If you are reading this, you may be in the fortunate position of having some choice. And if you are thinking seriously about this, you may also recognize that the default option, the one most advertised and normalized, may not automatically be the best one for you.
Even taking five focused hours to think through what your current choices are really doing could matter. Learning the tradeoffs between buying an ETF, leaving money in the bank, or building a more bespoke portfolio may reveal that your current setup is not as good as it could be.
There was a time when this kind of education was much harder to access. Before the internet became so widespread, many of the best resources were effectively gated. Today, that barrier is lower. With LLMs, it is easier than ever to search for information and have it explained at whatever level is useful to you. If an explanation does not make sense, you can ask for a simpler version until it does.
There is still a real danger though. Modern commercial and open-source LLMs are trained on human content, and human content includes bad incentives: clickbait, misinformation, shallow explanations, and noise. So while it is easier than ever to self-educate, it is also harder to know whether what you are learning is both true and useful.
The point of this course is not that every person should become a professional investor, nor that every default choice is wrong. It is that financial choices are still choices, and choices improve when their tradeoffs are visible. The chapters that follow are meant to make those tradeoffs easier to see: what kinds of accounts exist, how returns should be measured, what assets are available, and what mechanics matter before capital is put at risk.
Every profession is a conspiracy against the laity, and every profession’s jargon is meant to confuse and exclude those who aren’t part of the guild.
-Jason Zweig, financial journalist
Financial markets can certainly be a dangerous and intimidating domain. Abundant are the poor souls who waded into this territory unprepared and lost mightily for their efforts. This has, quite justifiably, engendered a healthy respect for the markets and the pitfalls that they may present for one’s financial well-being. Unfortunately, this has also led many to believe that the markets are better left alone and might even be rigged against them. This is too presumptive. American financial markets have been the greatest and broadest creators of wealth in the history of humanity and even offer opportunities for those who are not professional financiers to create abundance for themselves.
This guide will serve as an introduction to the world of trading and investing in financial markets. It will cover topics as varied as how to select an account, to how to assess returns, to how to profit from four legged options strategies. While not completely exhaustive, it should allow even those with no trading or investing experience to approach the markets with less trepidation.
The course will thus begin with what must be determined prior to and in order for any trades or investments to take place: selecting an account.
The term ‘account’ can refer to a wide variety of facilities. It has multiple meanings specific to finance, as well as meanings outside of the financial realm. In a more general context, it can denote a relating of events in chronological order or the keeping of record, possibly of goods sold or of services provided.
Financial services professionals use the term ‘account’ at a slightly more granular level. The first two uses essentially track what is owed to whom. In accounting, the term ‘account’ normally refers to a statement that presents or summarizes the tracking of activity in a ledger. It displays the transactions of an economic entity in the form of accruals, adjustments, credits, and debits. Accounts are also present in the realm of credit. A credit account allows an individual or an organization to borrow money. Examples of such accounts include lines of credit, credit cards, car loans, and mortgages. The lending entity in this scenario, often a financial institution, such as a bank, will charge the borrower interest on the money lent.
The second two uses of the term ‘account’ in finance pertain to when an individual or an organization emplace assets in the care of a financial institution. This concept, of entrusting an organization with the stewardship of one’s assets, originated in the twelfth century with the Poor Fellow-Soldiers of Christ and of the Temple of Solomon, more commonly known as the Knights Templar. About 90% of the members of this Catholic military order did not partake in activities related to combat. Rather, they would hold assets on behalf of others and make loans on those assets. This was the genesis of the banking industry.
In banking, an account is an arrangement through which an organization, often a bank or a credit union, holds the highly liquid financial assets, typically cash, of a customer. Customers can normally withdraw their assets from such accounts at their discretion. Finally, investment accounts, the type of account most relevant to this course, are arrangements through which a licensed brokerage firm holds the assets of an investor. In addition to the cash and cash equivalents that one might hold in an account with a bank (which may offer brokerage services through other divisions), investment accounts can also be used to trade other financial securities, such as stocks and bonds.
Most of those reading this course should be quite familiar with bank accounts. In fact, it is rather unlikely that anyone reading this course is not the owner of a bank account. Afterall, as of 2023, approximately 96% of American households had accounts with banks (or credit unions). Only about 4% of American households were unbanked and it is unlikely that a household without access to banking services would have the requisite capital, infrastructure, or interest to trade and invest.
This course would, however, be remiss to omit a more thorough exploration of this subject matter. There may be types of accounts or aspects of accounts that many who read this are unfamiliar with. John Locke said, “The only fence against the world is a thorough knowledge of it.” And in that vein, thorough this guide will attempt to be.
There are a myriad of types of investment accounts available to traders and investors. While there is a great deal of overlap between the services and fees associated with each type of account, there are also important points of differentiation. Significant differences lie in the regulations surrounding the funding of the accounts, the timing of withdrawals from the accounts, the tax implications of the activity in the accounts, and even the ability to trade certain financial securities in a certain manner in the accounts. Many accounts have specific purposes and the characteristics of these accounts are shaped with those in mind.
Possibly the most important point of overlap shared between the many types of investment accounts are the layers of protection and security imbued within them. First, the Securities and Exchange Commission (SEC) adopted Rule 15c3-3, better known as the Customer Protection Rule, in 1972. This policy safeguards the assets of investors by preventing the brokerage firms which hold the assets from using said assets to finance their own business or from coalescing an investor's cash with their own cash. Brokerage firms are frequently audited in order to ensure compliance with this rule.
The main impetus for the implementation of the Customer Protection Rule, however, was not a proliferation of malfeasance in the actions of brokerages. It was, instead, due to the paperwork crisis that arose on Wall Street in the late 1960s. At that time, trading volumes for equities listed on the New York Stock Exchange (NYSE) had surged to around 15 million shares per day. That was a drastic increase from the average volume of around 5 million shares per day seen earlier in the decade. While both are paltry sums by the standards of today, this was an unmanageable amount at that time. This is because there were no digital records that kept track of the ownership of securities. Brokers exchanged physical certificates to prove ownership and most pertinent information was recorded by hand.
At the end of the Second World War in 1945, the Securities and Exchange Commission allowed for settlement within two days of the date of the trade, or T+2. However, by the 1960s, the agency had been forced to increase the length of time permitted for settlement to five days due to the obstreperous amount of paperwork required. Even with the elongated windows for settlement, many certificates were mailed to an incorrect address or simply not mailed at all. Consistent mandatory overtime led to staffing issues at brokerage houses. In order to help alleviate the barrage of paperwork, stock exchanges were forced to close at least one day a week (they chose every Wednesday) and shorten trading hours on other days.
In addition to preventing the intermingling of investor assets with firm assets, the Customer Protection Rule required that brokerages maintain possession of the securities of their customers at all times. This was done in coordination with the creation of the Depository Trust Company (DTC) the following year of 1973. The Depository Trust Company is now a subsidiary of the Depository Trust & Clearing Corporation (DTCC), a firm established in 1999 to act as a holding company for both the Depository Trust Company and the National Securities Clearing Corporation (NSCC), formed in 1976.
The two subsidiary firms now settle multiple quadrillions of dollars worth of securities transactions each year. However, when it was first founded in 1973, more important than its functions in settling transactions and processing deliveries, was the role of the Depository Trust Company in acting as a custodian for securities. This allowed brokerages to hold their customer’s securities at a centralized location, significantly lessening the burden of back office managerial work. It also led to the automation and electronification of records of settlement for all certificates and securities. As many brokerages now hold customer’s assets at the Depository Trust Company or other firms like it, an extra layer of security is added between an investor and any unsavory acts of the organization at which they store their assets.
The second form of protection imbued in brokerage accounts comes in the form of coverage by the Securities Investor Protection Corporation (SIPC). Similar to the Federal Deposit Insurance Corporation, the Securities Investor Protection Corporation, established in 1970 by the Securities Investor Protection Act (SIPA), is a government corporation formed with the objective of providing security for investors.
While all broker-dealers registered in the United States are mandated to have membership with the Securities Investor Protection Corporation, it does not regulate them, nor was it ever intended to. The corporation was created to provide protection to investors should a member firm (brokerage) endure bankruptcy or other forms of financial hardship. Should a member firm file for bankruptcy, the Securities Investor Protection Corporation would oversee the liquidation process and expedite the return of investor assets. This includes a guarantee for up to $500,000 worth of assets, including up to $250,000 of cash.
If the schedule of an investor is not conducive to managing their own portfolio, or if an investor simply desires the guidance and competence of a knowledgeable professional, they can open a managed account. A managed account, while owned by an investor, is managed by a different individual, typically a registered investment advisor. The manager, hired by the investor, is given oversight over the account and is given the authority to control the activity of the account. Most money managers that oversee managed accounts seek high-net-worth individuals as clients and require a fairly high minimum initial deposit. This is done because the managers are often compensated by each client from a fee that is correlated to the assets under management (AUM) in the account.
Insurance companies also offer managed accounts of various sorts. These can be held separately from any insurance investments held with the firm. One of the products commonly offered is a fixed annuity. These instruments, often used to aid in funding retirement, grant the buyer payments of a specified amount on a predetermined schedule for a fixed amount of time or until death.
In finance, leverage refers to the concept of utilizing borrowed capital as a funding source as a means of amplifying the returns of a project or investment. Businesses will often use leverage in order to make the necessary investments to expand operations or to make acquisitions. This would be done in order to enhance the company’s ability to generate revenue in the future, making it easier to pay off the debt incurred as a result. Companies might choose to do this to raise capital instead of issuing more shares of stock so as to not dilute ownership. Traders and investors use leverage to increase the profit that a position utilizing financial securities yields. However, while they use leverage with the intent to increase profits, it also increases the downside risk of a position, and may lead to catastrophic loss if the position does not work out as intended.
Because there are risks associated with certain financial securities that would necessitate more capital than what an investor would need to take an initial position on them or than what the investor might have in their account, in order to trade such securities, a margin account is required. These accounts have access to, but do not necessarily need to ever use, leverage, or borrowed capital, provided by the brokerage. A trader or investor would utilize a margin account if they wanted to be able to control a buying power larger than the amount of money that they have in their account, in order to amplify returns, or so that they would have access to certain financial securities that necessitate a margin account, such as options and futures.
Standard brokerage accounts provide traders and investors with a great deal of flexibility. There are few restrictions with respect to funding and withdrawals and they often offer margins, allowing traders and investors to utilize a greater number of financial products and a greater number of trading strategies. Many options strategies, and futures trading in general, that are inaccessible when using certain other accounts are available through brokerage accounts. These accounts can belong to a single investor or multiple investors.
There are a myriad of types of retirement accounts or retirement plans available to Americans. The characteristic likely to delineate an account as a retirement account is its tax-advantaged status, as defined by the Internal Revenue Service (IRS), the agency of the federal government of the United States tasked with collecting federal taxes and administering the Internal Revenue Code. Adopted in 1986, the Internal Revenue Code is the most recent recodification of the tax laws of the United States.
The Internal Revenue Service is thus the singular entity that demarcates the characteristics and abilities imbued within each type of retirement account. It is also the entity which can choose to create new types of retirement accounts or phase out existing types of retirement accounts.
For most retirement accounts, the benefit of being tax-advantaged comes with the cost of certain restrictions. Saving for retirement is an endeavor that, both regulators and financial services professionals alike, believe should be undertaken in a careful and conservative manner. As such, most retirement accounts do not allow for speculative positions to be taken using derivatives, as these are seen to be quite risky. Thus, most trading strategies that utilize options and futures are not permitted to be executed by retirement accounts, with a few notable exceptions.
Similarly, these retirement accounts were created to help the working class afford to retire at the point when they were no longer able to work, without seeing a drastic diminishment in their quality of life. They were not intended to further enrich those who are already quite wealthy and would have little difficulty retiring while maintaining a high quality of life. As such, many retirement accounts have contribution limits, so that the wealthy cannot have all of their liquid assets accumulate free of tax.
It should not come as a surprise to anyone that is reading this that college has become exceedingly expensive. To many families, it has become prohibitively expensive. This is so even for public institutions, which were meant to provide a relatively affordable postsecondary education to America’s youth. Since 1963, the average annual cost of tuition at public 4-year colleges has risen by a factor of 40, greatly outpacing the rate of inflation during that time. Additionally, average annual tuition at these public 4-year colleges increased by at least 75% every decade from the 1970s to the 2000s. This inflationary phenomenon, however, has not been limited to public institutions. From the year 2000 to the year 2024, the average annual cost of tuition at private non-profit colleges and universities has increased at an annual rate of 4.12%.
While it certainly has not been able to provide a perfect solution, the Internal Revenue Service has taken steps to aid adolescents, their parents, and their extended family and friends in the burdensome task of paying for a postsecondary education. It has created tax-advantaged accounts into which sympathetic parties can deposit money on behalf of potential baccalaureate aspirants.
One may be able to contribute to a Coverdell ESA to finance the beneficiary’s qualified education expenses. Contributions must be made in cash, and they are not deductible. Any individual whose modified adjusted gross income is under the limit set for a given tax year can make contributions. Organizations, such as corporations and trusts can also contribute regardless of their adjusted gross income.[14]
As previously discussed, there are accounts created with the intended purposes in mind of transferring assets to a spouse or transferring assets to a minor. So too are there accounts created with the specific purpose of transferring assets in a more general sense. Both estates and trusts are financial vehicles created for the purpose of holding, managing, and transferring assets to one or more parties.
While often considered to be the domain of the very wealthy, trusts and estates can also be utilized to great effect by those of more modest means. They grant those who establish them a great deal of control over how their wealth is utilized and protected, both prior to and after their death. Regardless of whether an individual wants to make their beneficiaries’ inheritance incumbent upon achieving certain goals (such as graduating college or getting married) or whether they want their funds to be utilized for charitable means, the use of estates and trusts can better help the resources of that individual be used in a manner that they approve of.
Many of the previously listed bank accounts and investment accounts are not solely available to individuals or couples. Some are available to businesses, both large and small, as well. There may be additional requirements that must be met by a business in order to open and maintain these accounts, such as minimum initial deposit or minimum account balance, but this is dependent upon the bank or brokerage that issues the account. Access to bank accounts and investment accounts may allow a business to utilize its cash more efficiently.
[1] “Individual Retirement Accounts (IRAs)”, Charles Schwab, accessed February 26, 2025, https://www.schwab.com/ira.
[2] “Traditional IRA”, Charles Schwab, accessed February 26, 2025, https://www.schwab.com/ira/traditional-ira.
[3] “Roth IRA vs. Traditional IRA”, Charles Schwab, accessed February 26, 2025, https://www.schwab.com/ira/roth-vs-traditional-ira.
[4] “Roth IRA”, Charles Schwab, accessed February 26, 2025, https://www.schwab.com/ira/roth-ira.
[5] “Roth IRA vs. Traditional IRA”, Charles Schwab, accessed February 26, 2025, https://www.schwab.com/ira/roth-vs-traditional-ira.
[6] “Rollover IRA”, Charles Schwab, accessed February 26, 2025, https://www.schwab.com/ira/rollover-ira.
[7] “Other IRAs”, Charles Schwab, accessed February 27, 2025, https://www.schwab.com/ira/inherited-and-custodial-ira.
[8] “Other IRAs”, Charles Schwab, accessed February 27, 2025, https://www.schwab.com/ira/inherited-and-custodial-ira.
[9] “Brokerage Accounts”, tastytrade, accessed February 27, 2025, https://tastytrade.com/accounts/.
[10] “SEP-IRA (Simplified Employee Pension Plan)”, tastytrade, accessed February 27, 2025, https://tastytrade.com/accounts/sep-ira/.
[11] “401(k) plan overview”, Internal Revenue Service, accessed February 27, 2025, https://www.irs.gov/retirement-plans/plan-sponsor/401k-plan-overview.
[12] “IRC 403(b) tax-sheltered annuity plans”, Internal Revenue Service, accessed February 27, 2025, https://www.irs.gov/retirement-plans/irc-403b-tax-sheltered-annuity-plans.
[13] “Topic no. 313, Qualified tuition programs (QTPs)”, Internal Revenue Service, accessed February 27, 2025, https://www.irs.gov/taxtopics/tc313.
[14] “Topic no. 310, Coverdell education savings accounts”, Internal Revenue Service, accessed February 28, 2025, https://www.irs.gov/taxtopics/tc310.
[15] “What Is a Trust?”, Fidelity, accessed February 28, 2025, https://www.fidelity.com/life-events/estate-planning/trusts.
[16] “What Is a Trust?”, Fidelity, accessed February 28, 2025, https://www.fidelity.com/life-events/estate-planning/trusts.
[17] “What Is a Trust?”, Fidelity, accessed February 28, 2025, https://www.fidelity.com/life-events/estate-planning/trusts.
Do not take yearly results too seriously. Instead, focus on four- or five-year averages.
-Warren Buffett, investor
Once an account exists, the next question is what should count as success. That question is harder than it first appears. A return can look excellent in isolation and mediocre when compared with a benchmark. It can look safe until one notices the size of the drawdowns required to earn it. It can look large before taxes, inflation, fees, and trading costs, and much smaller afterward. Evaluating returns is therefore not just a matter of asking whether a number is positive. It is the process of understanding what was earned, over what period, with what risk, against what alternative, and after what costs.
The simplest return measures the percentage change between an ending value and a beginning value. If an account begins the year at $10,000 and ends at $11,000, the simple return is 10%. If it ends at $9,000, the simple return is -10%. This calculation is useful because it is easy to understand, but it only describes one interval. It does not explain how smooth the path was, whether deposits or withdrawals affected the account, or whether the result was good relative to other available choices.
Simple return - The percentage gain or loss over a stated period. It is calculated as ending value divided by beginning value, minus one.
Cumulative return - The total return over a multi-period span. If a portfolio rises 10% in year one and 10% in year two, the cumulative return is 21%, not 20%, because the second year return is earned on a larger base.
Returns over different lengths of time cannot be compared cleanly without annualization. A 30% gain over five years and a 30% gain over one year are not equivalent. The annualized return, often expressed as compound annual growth rate, or CAGR, converts a multi-year result into the constant yearly return that would have produced the same ending value.
Compound annual growth rate (CAGR) - The smoothed annual rate of return required to turn a beginning value into an ending value over a stated number of years. The formula is: CAGR = (ending value / beginning value)^(1 / years) - 1.
Annualized returns are useful because investing is an exercise in compounding. A strategy that earns a modest return consistently for many years may produce more wealth than a strategy that has one extraordinary year followed by several years of stagnation or loss.
The arithmetic average adds each periodic return and divides by the number of periods. The geometric average accounts for compounding. This difference matters because losses require larger gains to recover. A portfolio that gains 50% in one year and loses 50% the next has an arithmetic average return of 0%, but the investor is not whole. One dollar grows to $1.50, then falls to $0.75. The compounded result is a 25% loss.
Arithmetic average return - The simple average of periodic returns. It can be useful for describing typical single-period outcomes, but it can overstate the long-term growth rate of volatile returns.
Geometric average return - The compound average return across multiple periods. It is usually the more relevant measure for investors evaluating long-term wealth growth.
A nominal return is the return before adjusting for inflation. A real return is the return after adjusting for inflation. If a portfolio earns 6% in a year when inflation is 3%, the investor has increased purchasing power by roughly 3%. If a savings account earns 2% while inflation is 4%, the account balance may rise, but the owner can buy less with that money than before.
Nominal return - The stated return before adjusting for inflation.
Real return - The return after accounting for inflation. Real return is what matters for purchasing power.
Two portfolios can earn the same return while creating very different experiences for the investor. One might rise steadily. Another might swing violently between large gains and large losses. Volatility measures the variation of returns around their average. Drawdown measures the decline from a previous peak to a later trough. Both are important because investors do not experience final returns in isolation. They experience the path.
Volatility - A measure of how much returns fluctuate. Higher volatility generally means a wider range of possible outcomes.
Drawdown - The percentage decline from a portfolio high point to a later low point. A portfolio that falls from $100,000 to $75,000 has a 25% drawdown.
Maximum drawdown - The largest peak-to-trough decline over a measured period. It is one of the clearest ways to see how painful a strategy has been historically.
A return is only meaningful when considered alongside the risk required to earn it. A strategy that earns 12% with low volatility is different from a strategy that earns 12% while regularly losing 40% of account value. Risk-adjusted return measures attempt to compare return to risk so that investors can distinguish between skill, leverage, luck, and exposure to broad market forces.
Sharpe ratio - A measure of excess return per unit of volatility. It compares a portfolio return above the risk-free rate to the volatility of that portfolio.
Sortino ratio - A variation of the Sharpe ratio that focuses on downside volatility rather than all volatility. It is often useful because investors usually care more about downside movement than upside movement.
Risk-free rate - The return available from an asset generally treated as having very low default risk, often represented by short-term United States Treasury bills. It is used as a baseline because risky investments should be expected to offer compensation above what can be earned with very little credit risk.
A portfolio should usually be compared with a relevant benchmark. A United States large-cap equity portfolio might be compared with the S&P 500. A short-term bond portfolio might be compared with a Treasury bill index. A strategy focused on small companies, international stocks, or options should not be judged solely against a benchmark that does not resemble its opportunity set.
Benchmark - A reference index or portfolio used to evaluate performance. A good benchmark should be investable, measurable, and similar enough to the strategy being evaluated that the comparison is meaningful.
Alpha - Return in excess of what would be expected after accounting for exposure to a benchmark or risk factor. Positive alpha is often used as a shorthand for value added by the investor or manager, though estimating it properly can be difficult.
Beta - A measure of sensitivity to a benchmark. A portfolio with a beta of 1.0 to the S&P 500 tends to move similarly to that index. A beta above 1.0 indicates greater sensitivity, while a beta below 1.0 indicates less sensitivity.
The return that matters is the return the investor keeps. Expense ratios, advisory fees, commissions, bid-ask spreads, market impact, borrowing costs, and taxes can all reduce realized results. This is especially important for active trading strategies. A strategy that appears profitable before costs may be unprofitable after costs, and a strategy that trades frequently may create taxable gains even when the investor would prefer to defer taxes.
Expense ratio - The annual fee charged by a fund as a percentage of assets.
Slippage - The difference between the expected execution price of a trade and the actual execution price.
Turnover - The rate at which positions are bought and sold in a portfolio. High turnover can increase transaction costs and taxable events.
Deposits and withdrawals complicate performance measurement. If an investor adds money just before a large gain, the account result will look different than if the same gain occurred before the deposit. Time-weighted returns attempt to remove the impact of external cash flows and are commonly used to evaluate managers. Money-weighted returns include the impact of cash flow timing and are often more representative of the investor's actual experience.
Time-weighted return - A performance measure that breaks returns into subperiods around deposits and withdrawals, then compounds those subperiod returns. It is useful for evaluating investment decisions separate from cash flow timing.
Money-weighted return - A performance measure that incorporates the size and timing of cash flows. Internal rate of return is a common money-weighted return calculation.
Evaluating returns is less about finding one perfect number than about building a habit of comparison. Good analysis asks what was earned, what could have been earned instead, what risks were accepted, what costs were paid, and whether the outcome fits the purpose of the capital. That framework makes the rest of the investment process more disciplined.
Our country’s businesses will continue to efficiently deliver goods and services wanted by our citizens. Metaphorically, these commercial “cows” will live for centuries and give ever greater quantities of “milk” to boot. Their value will be determined not by the medium of exchange but rather by their capacity to deliver milk. Proceeds from the sale of the milk will compound for the owners of the cows, just as they did during the 20th century when the Dow increased 66 to 11,497 (and paid loads of dividends as well).
-Warren Buffett, investor
After explaining what is necessary to trade and invest, and establishing a framework for setting reasonable goals and assessing results, it is important to understand the realm of possibilities for capital allocation. One might query as to what are the various elements of a portfolio that one could transact in, in order to elicit strong returns. A discussion of assets and their delineation into and within classes is in order.
An asset is a resource or property that has economic value. It can be owned by an individual, a company, an institution, or a government and is expected to provide benefits, such as the generation of cash flows or the reduction of expenses, over time. An asset can be something tangible, such as land, infrastructure, or equipment, or something intangible, such as intellectual property, a brand, or property rights.
Assets are reported on the balance sheets of businesses and institutions, and constitute one side of the fundamental equation of accounting. On these balance sheets, they are often classified as either current assets, fixed assets, financial assets, or intangible assets.
There are many ways in which one could divide the totality of assets into classes. One such method can be gleaned from Warren Buffett. The Oracle of Omaha often delineates between ‘productive assets’ and ‘non-productive assets’. The quote at the beginning of this section is from a 2011 letter to shareholders in which he explains his aversion to gold. He believes gold to be a ‘non-productive asset’, as it does not earn or produce anything.
More often, however, asset classes are groupings of investment instruments that exhibit similar characteristics. They may be subject to the same laws and regulations or may behave similarly in the marketplace. When divided thusly, assets are often grouped into classes that include equities, fixed income, commodities, and real estate.
As previously stated, Warren Buffet has expressed a strong preference for assets that are ‘productive’ and a strong aversion to assets that are not ‘productive’. Quite simply, ‘productive assets’ are able to produce goods or yield services from which cash flows can be derived, whereas ‘non-productive assets’ cannot.
Gold is probably the most famed non-productive asset. It is much beloved by certain investors who claim it to be a strong store of value and a viable means of hedging against inflation. This, however, is an exceedingly generous interpretation of reality. Gold has been shown to not have a strong correlation to fluctuations in the Consumer Price Index (CPI), meaning it is unlikely to serve well as a hedge against inflation during the times in which it is a going concern.
The price of gold has increased over the past 50 years at a rate that has outpaced inflation, but many assets have done that. Gold actually underperformed a basket of commodities from 1971 to 2024, as many of the other commodities in the basket had practical uses. Additionally, gold significantly underperformed American stocks during that time period. Stocks and other productive assets are likely to serve as a better hedge against inflation than gold due to the fact that the prices they charge for their goods and services can be adjusted in accordance with inflation. Gold has little in the way of practical uses and thus its price only goes up due to the perpetuation of the Greater Fool Theory
The Greater Fool Theory stipulates that investors or traders will buy an asset, regardless of whether or not they believe it to be overpriced, due to the fact that they believe there are other investors or traders who are foolish enough to buy the asset at an even more overvalued price. And, while this strategy may work for a period of time, eventually, there will be no greater fools left to sell to.
The ability of an asset to generate cash flows is one very simple methodology of delineating assets into classes. Delineating assets by whether or not they can be touched may appear to be equally simple. However, this methodology may, in fact, be somewhat monochrome, with shades of gray, rather than simply black and white.
While, historically, certificates of ownership for financial securities, such as bonds and shares of stock, were issued, this is rarely done in the twenty-first century. Additionally, these certificates were only representative of ownership of actual tangible assets, and were not the valuable assets themselves. Now, such securities are almost always digital representations of claims upon the assets of the institution that issued them. Thus, even though they are not, themselves, tangible, their claim upon tangible assets qualifies them as tangible assets.
For a myriad of reasons, companies engage in accounting practices. This may be done as a means of reporting information to oversight agencies, regulators, or taxation authorities (such as the Internal Revenue Service (IRS) of the United States). It may also be done for internal use, as a way to determine results for various segments of the business and effective means of deploying capital in the future. Part of this process entails classifying the assets of a company and assessing their value. The assets are typically classified as either current assets, fixed assets, financial assets, or intangible assets.
While the standard used in the United States for financial accounting is Generally Accepted Accounting Principles (GAAP), most other countries used International Financial Reporting Standards (IFRS). Accounting practices have become standardized so as to increase the reliability and relatability of the financial statements. Financial statements, which include income statements, balance sheets, cash flow statements, and statements of retained earnings, are standardized so that stakeholders and shareholders are better able to assess the performance of a company. Assets are reported on the balance sheet and constitute one side of the fundamental equation of accounting.
Assets = Liabilities + Owner’s Equity
Probably the most significant and relevant methodology for classifying assets for this course is to do so by delineating along the lines of regulation. This is, in essence, borrowing one of the methodologies with which governments classify these assets. The reason that this is the most relevant is because it is the most exact.
Dividing assets based upon productivity or palpability leaves two very broad asset classes that are not particularly useful beyond basic conceptual understanding. While there are more than two asset classes in the balance sheets yielded by financial accounting, and these financial statements are used for government purposes, this methodology still groups very dissimilar assets together. Using this methodology, assets are still lumped into a small handful of classes, one of which, financial assets, has an incredible amount of diversity and complexity.
While delineating assets via their government regulation and oversight may yield groupings that have components with dissimilar risk profiles, payoff structures, useful lives, and even tax implications, the variations will be significantly less stark than with any of the previous means of classification.
Shareholders’ equity is the value of a company that would remain if it were to sell off all of its assets and pay off all of its liabilities. This figure is representative of how much a company is worth, and thus, how much should be returned to its owners if it were to be sold. The owners of a company, those who hold its equity, are known as “shareholders”. While one can hold equity in any number of assets, not just companies, equity markets, or, as they are more commonly referred to as, ‘stock markets’, deal mainly with the ownership of companies.
Fixed income refers to investment instruments that provide fixed, or scheduled, payments or distribution of interest. Institutions that issue fixed income securities are considered to be indebted to the investors that hold said securities. Debt can be found in the liabilities portion of a balance sheet. A myriad of institutions issue debt, ranging from sovereign governments, to municipal governments, to government-owned institutions, to corporations, to non-profit institutions, such as universities.
The vast majority of fixed income instruments have a maturity date at which the principal amount that was originally invested is repaid. Holders of a company’s debt are paid prior to any dividends being paid out. Even preferred shares are subordinated relative to debt. If a company were to declare bankruptcy, those that hold its debt would receive payments prior to any dividends paid to those that hold its preferred stock or common stock. Fixed income securities are thus often seen as having a lower risk profile than equities, and will normally yield lower returns in accordance.
Currency and certain securities that can be easily converted into currency constitute the asset class of cash and cash equivalents. While bank accounts and short-dated debt securities are considered to be cash equivalents, equities are not, even though they are quite liquid. This is, in part, due to the fact that equities can wildly fluctuate in value, while the value that debt securities will yield is fixed.
Cash and cash equivalents is considered to be the asset class with the lowest risk profile, as well as the asset class with the lowest return profile. Due to the fact that there is little chance of default on short-dated debt securities, entities that issue such securities are able to offer a lower rate of return. As there is little risk of losing the principal amount invested, the main risk associated with this asset class is whether or not the interest on the principal is able to keep up with the rate of inflation, so that the real value of one’s assets does not depreciate. Additionally, there is an opportunity cost often associated with this asset class, because if an investor keeps their portfolio in cash, they might miss out on opportunities in the equities and fixed income markets that would yield better returns.
The asset class of commodities encompasses all of the raw materials that are used as inputs in the manufacturing of consumer products. Each unit of these raw materials is considered to be interchangeable with a different unit of goods of the same type, in spite of the fact that the quality of the commodity may differ slightly across each unit. This is because when commodities are traded on an exchange, they must meet a minimum standard or basis grade. Commodities can be traded either by directly buying and selling them in the spot market or by using derivatives such as options and futures.
Not every commodity, however, can be traded using futures. The United States Congress passed the Onion Futures Act in 1958 and it was signed into law by President Dwight Eisenhower on August 28 of that year. The law banned the trading of futures contracts on onions, and, in 2010, was updated to include futures contracts on motion picture box office receipts. The Chicago Mercantile Exchange, which was founded in 1898 as the Chicago Butter and Egg Board, saw a steep decline in revenue generated from trading in butter futures contracts in the 1930s as trading in the commodity dwindled. This was due to the government subsidization of the dairy industry at that time. To make up for this loss of revenue, the exchange introduced futures contracts on onions in 1942. By the mid-1950s, onion futures contracts had become the most traded product on the exchange and accounted for approximately 20% of its trading volume. It was at this point, in 1955, that Vincent Kosuga, an onion farmer from New York, and his friend, Sam Siegel, enacted a plan to corner the onion market. By the fall of that year, the two held up to 98% of the onions in Chicago. This drove prices up, at which point they entered into short positions on onion futures contracts. In spring of 1956, they flooded the market causing the price of a 50 pound bag of onions to drop from $2.75 to $0.10. They reaped an enormous windfall from this strategy that would never be duplicated, as then-Congressman and future president Gerald Ford championed the Onion Futures Act at the behest of farmers, many of whom had been adversely affected by the ploy.
In addition to raw materials used in manufacturing, commodities can also come in the form of certain agricultural products or the hydrocarbon substances that dominate global energy markets. Commodities are often divided into two groups: hard commodities and soft commodities. Hard commodities are those which are mined or extracted, such as petroleum, ore, and metals. Soft commodities are those which are grown, such as agricultural products.
Commodities as an asset class are often used as a hedge against inflation. Most famously, gold is used as a hedge against inflation. While a unit of any given commodity is not itself a productive asset, many commodities are used by companies, which are themselves productive assets. Gold, however, has little practical use and is mainly bought and sold for speculative purposes. It has, historically, underperformed equities, underperformed baskets of mainly useful commodities, and shown little correlation to inflation, making it an inapt hedge.
Land and the permanent structures contained on that land constitute the asset class of real estate. Real estate is a form of real property, and different then personal property. While real property refers to land and the structures permanently attached to that land, personal property refers to goods that can easily be removed from the land, such as cars, boats, aviation vehicles, farm vehicles, furniture, clothing, electronics, jewelry, and innumerable others.
There are a myriad of different ways that individual investors can gain exposure to the five prominent categories of real estate, which are land, commercial, industrial, residential, and special use. The purchase of a home would be an example of direct investment in real estate, while putting money into a fund that purchases homes, buildings, farmland, or timberland would be an example of indirect investment.
Real estate is often considered to be a somewhat defensive asset class to invest in, not just because it can offer both steady income and capital appreciation, but because shelter, commercial spaces, and farmland are each something of a necessity to society continuing in an orderly manner. This does not mean that it is an asset class that can be invested in haphazardly, however. Real estate is rather illiquid and highly influenced by local factors, so direct investment should be accompanied by a certain level of expertise.
In recent years, a new asset class has been introduced to the world; digital assets. With the rise of the internet over the past few decades, it has become viable to create and store assets that only exist in the digital realm. A digital asset is thus anything that is solely digital that is identifiable, has established ownership, and has value.
While digital assets technically encompass a wide spectrum of effects, including documents, photos, videos, music, audio, videos, illustrations, animations, logos, manuscripts, emails, email accounts, social media accounts, gaming accounts, and metadata, it was not until the aftermath of the 2008 Financial Crisis that the masses became acquainted with blockchain technology and the shift that it would cause in our collective perception of digital property.
A blockchain is a distributed, or shared, database or ledger, that stores information across a network of computers, or nodes. The information is stored in blocks that are linked together by means of cryptography. As blocks cannot be changed, the need for third parties in the recording of transactions is minimized. This technology has emboldened some to attempt to displace elements of the current financial system and usurp the positions of many of its institutions. Most notably, it has led to the creation of new mediums of exchange, cryptocurrency, that are looked at by some as an alternative to government issued fiat currency.
While there has been a great deal of excitement surrounding digital assets in recent years, most of them could still be categorized as non-productive assets. While they do not have gold’s impressive, millenia-spanning history of exemplifying the Greater Fool Theory, digital assets have even less practical use and ability to generate income. They have been used almost exclusively as tools for speculation, and Bitcoin, the first and most well-known cryptocurrency, already has a market capitalization of over $1 trillion, despite the fact that it is rarely used in transactions. It serves no real purpose, other than to be used by speculators as a hedge against inflation in a manner similar to gold. In fact, Bitcoin is sometimes referred to as “digital gold”. However, the majority of digital assets are now worth less than they were when they were created, including over 95% of non-fungible tokens.
Derivatives are financial contracts that derive their value from an underlying asset or, occasionally, an underlying index. There are, in fact, derivatives of each of the previously discussed types of asset, whether that be equity securities, fixed income securities, cash, commodities, real estate, or cryptocurrency. Changes in the price of a derivative stem from changes in the price of its underlying asset or changes in the level of its underlying index. These contracts normally have a set expiration date.
Though derivatives predate the relatively recent advent of cryptocurrency, most other types of assets have a longer history as financial securities or marketable economic resources. While Venetian merchants began trading debts held by moneylenders in the fourteenth century and citizens of the Dutch Republic were able to buy shares of the United East India Company when it was chartered in 1602, it was not until 1697 that the first semblance of the trading of derivatives occurred. Although it was not authorized by the Tokugawa shogunate until 1730, the Dojima Rice Exchange was unofficially founded in Osaka, Japan at the end of the seventeenth century. Since many people in Japan at that time were paid in rice, including the samurai class and the daimyoࠡ (feudal lords), it was important to be able to get a stable, predictable rate at market so that people could have a stable, predictable income so as to meet their daily needs. Thus, in 1710, the Dojima Exchange began the facilitation of, what can be considered, the first futures contracts (nobemai).
One can be forgiven for wondering as to why, if derivatives were originally the purview of seventeenth century rice farmers and soldiers, utilized to mollify volatility in their incomes, their reputations have become mired in association with notions of opaqueness, recklessness, and greed in recent decades. In Berkshire Hathaway’s 2002 annual report, Warren Buffet quite famously stated that “I view derivatives as time bombs” and that “derivatives are financial weapons of mass destruction”. And yet, Buffet himself has quite famously used derivatives to improve returns of Berkshire’s portfolio. The resolution to this seeming dissonance lies in two simple facts. First, there is a great deal of variation in the structure of many derivatives and even in the way that traders and investors can utilize the same derivative. Second, there is a difference between how derivatives can be used for the mitigation of volatility and how they can be used for speculation.
In the 2002 annual report, Buffet referenced the total-return swaps, utilized by the, now infamous, hedge fund Long-Term Capital Management (LTCM) in the late 1990s. These derivatives, used almost exclusively by institutional money managers to obtain leveraged speculative exposure, caused LTCM to ultimately collapse. The fallout from this boondoggle had such grand reverberations throughout the financial system that the Federal Reserve felt that it necessitated an intervention. Total-return swaps also caused the collapse of Bill Hwang’s family office fund Archegos, in 2021, and even one of its counterparties for the derivatives in the bank Credit Suisse. There was a significant downturn in the market that occurred due to the recklessness of Hwang and the inability of his counterparties to fully grasp how leveraged he was at the time due to those swaps.
In both the case of LTCM and Archegos, it was unclear exactly what the possible risk was to the firms posed by the derivatives. However, when Berkshire Hathaway sold put options on the S&P 500, the FTSE 100, the Euro Stoxx 50, and the Nikkei 225 throughout the mid 2000s, Buffet knew exactly how much he was risking. A maximum loss would be reached in the incredibly unlikely event that any of those indexes reached 0, and that was still well within the risk tolerance of the firm. While LTCM, Archegos, and Berkshire all used derivatives as tools for speculation, the risk profiles for the speculations of LTCM and Archegos were entirely different than that of Berkshire.
Similarly, if a farmer wants to ensure that he is able to receive a certain price for his crop, and does not want to risk the possibility that he may not be able to get that much in the market by the time it is ready for harvest, he can sell a futures contract. In doing so, he must deliver a specified amount of his crop at a specified date and will receive a specified amount of money in return. The farmer is willing to forgo the possibility of further upside (selling his crop at a price higher than the specified price), in return for eliminating the downside (of selling his crop at a price lower than the specified price). This allows the farmer to minimize the effects of market fluctuations in his income. Such a strategy is only possible, however, because the farmer has the commodity, or actuals, in the amounts specified in the contract. If a trader who does not grow his own crop were to sell the same futures contract, if the price of the underlying crop were to go above the specified price, the trader would have to buy the crop on the market at this higher price and sell it at the lower, specified price, resulting in a loss. As there is no limit to the price that a commodity can rise to, the maximum theoretical loss for such a trade is infinite.
While certain derivatives may bring undue risk to both their buyer and their seller, as a lack of clarity is inherent in their very structure, such derivatives are not particularly relevant to the average investor or trader. Most of them require large amounts of capital, regulatory licences, and institutional backing. Other derivatives, however, can be used to mitigate volatility in the returns of a portfolio, the revenue generated by a business, or the expenses paid by a business. Some can also be used to greatly reduce risk and capital requirements when looking to gain directional exposure. It would be prudent to focus on such derivatives.
There has been a great proliferation of various forms of investment funds that has taken place over the past few decades. Investors have flocked to many of these, particularly index funds, in recent years due to the diversification that they provide and the relatively low fees and costs required of them. While there were precursors to modern funds beginning in the Dutch Republic in the late eighteenth century, they operated on a relatively small scale. And while they shared the aim of providing diversification to investors with their present-day counterparts, they did so in a manner that is different to how many firms provide diversification today.
It was not until 1973 that the appeal of investment funds came to be more widely perceived by the investing public. During the summer months of that year, a recent graduate of the MBA program at the University of Chicago by the name of Rex Sinquefield developed the first passively managed index fund at the age of 28, under the auspices of the American National Bank of Chicago. The fund sought to track the performance of the S&P 500 Index. Due to the high transaction costs and low liquidity of the stocks of some of the smaller companies in the index at that time, Sinquefield did not hold every stock in the index in his fund. However, he was still able to almost exactly mimic the performance of the index. By 1980, the fund held over $12 billion under management, a very impressive amount for the time.
Three years later, in 1976, The Vanguard Group, founded by John C. Bogle in 1975, launched the First Index Investment Trust. Like Sinquefield’s fund, it sought to track the returns of the S&P 500 Index. It has since been renamed as the Vanguard 500 Index Fund and is currently the oldest and second largest mutual fund by assets under management available in the world today. The only mutual fund that is larger by assets under management is Vanguard’s Vanguard Total Stock Market Index Fund. The Vanguard Group is now the world’s second largest company by assets under management, the largest provider of mutual funds in the world, and the second largest provider of exchange traded funds in the world.
While The Vanguard Group was indeed founded in 1975, the true genesis of the firm predates its founding by over two decades and is quite indicative as to why index funds have become so popular in recent years. During his senior year at Princeton University in 1951, for his undergraduate thesis, Bogle wrote a paper comparing the returns of active fund managers to the returns of the broader stock market indices. He found that active fund managers rarely achieved higher returns than their benchmark index. And, on the rare occasions that they did perform better, the fees associated with the management of the funds often reduced the returns that the investors in the funds realized to below the returns of the benchmark index.
The conclusion Bogle drew from his thesis was axiomatic, almost truistic: it would be beneficial for investors to be given the opportunity to invest in funds that mimic benchmark indices. These indices generally perform better than actively managed funds and, because they do not require due diligence from a team of investment professionals, they can be passively managed quite cheaply. It was not until 25 years later, however, that Bogle was able to act upon his early findings.
Index funds have grown significantly in popularity since their infancy in the days of Sinquefield and Bogle. In 2021, the $8.4 billion invested in equity focused index funds accounted for approximately 16% of the $52 billion aggregate market capitalization of the stock market of the United States. This is having some distorting effects on how many stocks trade. The price of a stock may now be affected as much by whether or not it is included in a certain index as it is by the fundamental value of the underlying company. A stock that is added to an index would be immediately purchased by all of the funds that track that index, thus inflating its price relative to its value. When less than 1% of the market was controlled by index funds, these distorting effects were negligible. However, this no longer holds true. It is still not entirely clear if there is a percentage of the stock market allocated to index funds that would serve as a tipping point, beyond which the market would be left to deal with drastic negative ramifications. It is also not entirely clear what those negative ramifications might be.
The final class of assets is alternative assets. This is something of a ‘catch-all’ for assets that do not fit into any of the aforementioned classes. Alternative assets can range from an investment with certain financial services firms, to physical goods. It is rare that any alternative asset trades on an exchange, making them fairly illiquid. Investors often buy into this class of assets because it is believed that they provide uncorrelated returns relative to all or most of the other classes. For some assets within this class, that insinuation is almost assuredly true, while for others it is a tad more dubious. Regardless, individuals and institutions alike have greatly increased their exposure to alternative assets in the twenty-first century.
The final portion of this section will discuss, not how assets are divided into classes, but rather, how the firms that control or issue these assets are classified. One may be forgiven for believing that, within the context of this course, companies such as Alphabet, Amazon, Apple, Microsoft, and Meta are all considered to be technology companies. Listen to most news sources for any length of time, and one is likely to hear some discussion that mentions these firms focused on ‘Big Tech’. Often, the discussion will be in regards to the undue influence that these ‘technology’ companies and their managers and large shareholders have on the economy, politics, culture, and privacy. However, of the five firms mentioned, only two of them would be viewed as technology companies by investment professionals. This is because, under the Global Industry Classification Standard (GICS), Alphabet and Meta would be considered to be Communication Services companies, while Amazon would be a Consumer Discretionary company. Only Apple and Microsoft would fall into the category of Information Technology firms.
The Global Industry Classification Standard is a financial industry taxonomy developed by Morgan Stanley Capital International (MSCI) and S&P Global Ratings (formerly Standard & Poor’s) in 1999. It is a four-tiered structure that currently divides companies into 11 sectors, 25 industry groups, 74 industries, and 163 sub-industries. S&P plies this system to public companies, leading money managers to follow suit when structuring the portfolios of their funds.
The S&P 500, the world’s most tracked stock market index, selects stocks based on, not solely their size, but rather, their size relative to others within their Global Industry Classification Standard sector. The market capitalization of that sector will then determine the relative weighting of the stock within the famed index. Different indices will use different weightings or may only use a portion of the firms covered by these standards, but there is an enormous amount of money that is tied directly to the classification of companies. There are many sector and industry exchange traded funds and mutual funds that offer traders and investors exposure to specific portions of the market. This way, if a fund manager foresees turbulence, they can increase their holdings in defensive areas of the market. Similarly, if the manager believes the foreseeable future is bright, they can move their money into a sector that might take advantage of that.
This course will not delve into great detail about each of the 273 categories that a company can be divided into based upon this taxonomy. It is not difficult to find the lines of delineation for this methodology on the internet and there are free tools that will allow those interested to find out the sector and industry classification of a publicly listed company. However, a brief description of each of the 11 sectors that are the most basic means of delineation will be included below, as MSCI and S&P define them.
[1] “Methodology Information; GICS: Global Industry Classification Standard”, S&P Global Ratings, accessed February 13, 2025, https://www.spglobal.com/spdji/en/landing/topic/gics/.
[2] “Methodology Information; GICS: Global Industry Classification Standard”, S&P Global Ratings, accessed February 13, 2025, https://www.spglobal.com/spdji/en/landing/topic/gics/.
[3] “Methodology Information; GICS: Global Industry Classification Standard”, S&P Global Ratings, accessed February 13, 2025, https://www.spglobal.com/spdji/en/landing/topic/gics/.
[4] “Methodology Information; GICS: Global Industry Classification Standard”, S&P Global Ratings, accessed February 13, 2025, https://www.spglobal.com/spdji/en/landing/topic/gics/.
[5] “Methodology Information; GICS: Global Industry Classification Standard”, S&P Global Ratings, accessed February 13, 2025, https://www.spglobal.com/spdji/en/landing/topic/gics/.
[6] “Methodology Information; GICS: Global Industry Classification Standard”, S&P Global Ratings, accessed February 13, 2025, https://www.spglobal.com/spdji/en/landing/topic/gics/.
[7] “Methodology Information; GICS: Global Industry Classification Standard”, S&P Global Ratings, accessed February 13, 2025, https://www.spglobal.com/spdji/en/landing/topic/gics/.
[8] “Methodology Information; GICS: Global Industry Classification Standard”, S&P Global Ratings, accessed February 13, 2025, https://www.spglobal.com/spdji/en/landing/topic/gics/.
[9] “Methodology Information; GICS: Global Industry Classification Standard”, S&P Global Ratings, accessed February 13, 2025, https://www.spglobal.com/spdji/en/landing/topic/gics/.
[10] “Methodology Information; GICS: Global Industry Classification Standard”, S&P Global Ratings, accessed February 13, 2025, https://www.spglobal.com/spdji/en/landing/topic/gics/.
[11] “Methodology Information; GICS: Global Industry Classification Standard”, S&P Global Ratings, accessed February 13, 2025, https://www.spglobal.com/spdji/en/landing/topic/gics/.
“It is literally true that millions come easier to a trader after he knows how to trade, than hundreds did in the days of his ignorance.”
— Jesse Livermore, stock trader
It should go without saying, but any success that an individual might have in the implementation of their trading and investing strategies is predicated upon actually knowing how to trade. This may appear to be axiomatic in meaning, but it is not. Knowing how to trade, in this context, is not analogous to the mastery of trading stratagems that Jesse Livermore spoke of in the quote above. It is, instead, a reference to a knowledge of trading mechanics. This chapter will discuss where equities are traded, through what mechanisms they are traded, and how to place an order to buy or sell a stock.
Institutional and professional traders have multiple options when sending orders. Broker-dealers (BDs) must subscribe to specific market centers for traders to participate in them. The available trading venues depend on the broker one chooses, as not all brokers subscribe to an extensive range of options due to the associated costs.
An exchange is a marketplace where securities, commodities, derivatives, and other financial instruments are traded. The primary function of an exchange is to ensure fair and orderly trading while providing efficient dissemination of price information for securities. There are ten major exchanges utilized by professional traders.
All NYSE-listed stocks trade on the NYSE exchange, but they can also be traded on other exchanges and alternative trading systems. The ability to access these options depends on an individual's broker-dealer, as they may not subscribe to all available venues due to costs.
An alternative trading system (ATS) is a non-exchange trading venue that facilitates the buying and selling of securities, typically outside of traditional stock exchanges like the NYSE or NASDAQ. Defining characteristics of alternative trading systems include:
The purpose of alternative trading systems is to facilitate the off-exchange trading of securities. Order matching services are administered with price-time priority and use auctions or hidden liquidity pools. This liquidity provision is one of the features that attracts institutional investors and market makers. They also provide anonymity and reduced market impact for large institutional trades, which prevents them from impacting market prices. They offer flexibility in order execution and order parameters, such as time-in-force and pegged orders.
There are a myriad of types of securities that can be traded on these systems, including equities, bonds and other debt instruments, derivatives, and, in select jurisdictions, cryptocurrencies. Alternative trading systems are particularly useful for trading small-cap equities and other illiquid stocks.
Regulations pertinent to maintaining compliance for alternative trading systems, including Regulation ATS, dictate that:
Dark pools are private trading venues where institutional investors can trade large quantities of securities without publicly disclosing trade details such as price and volume. These private exchanges prevent significant market impact and allow for discreet execution.
There are a number of strategies that can be implemented in order to execute orders in dark pools. Lime Trading offers a number of strategies, which include:
There are numerous alternative trading systems and dark pool options available, each with specific order types and execution strategies. Not all brokerages provide access to the same venues and order types.
The main tool for placing a trade is a montage. It consists of three parts: the Level 1, the Level 2, and the Level 3.
The Level 1 in a trading montage provides the most basic market data. It is typically available to all traders. It includes:
Level 1 data is useful for general trading, but lacks market depth. It does not show multiple bid/ask levels, like Level 2 data does, nor does it provide order modification access, like Level 3 data does. It is typically included in standard brokerage accounts and used for basic trade decisions.
Level 2 data in a trading montage provides market depth information by displaying the order book beyond just the best bid and ask prices. It is commonly used by active traders and includes:
Unlike Level 1 data, which only shows the best bid and ask price with the last trade, Level 2 provides a broader view of market sentiment and potential price movements. However, it does not allow direct order modification like Level 3 data, which is reserved for market makers and professionals with exchange access.
Level 3 data in a trading montage refers to the most detailed market data available. It is typically used by market makers, proprietary traders, and institutions. It provides full-depth-of-book information, including:
Retail traders usually have access to Level 1 data (best bid/ask) or Level 2 data (depth of market with multiple bid/ask levels). Level 3 data is generally reserved for professionals with exchange memberships.
The process of placing a trade on a professional trading platform begins by filling out an order ticket. If it has been programmed, a hotkey can also be used to place a trade. Hotkeys are preprogrammed orders that can be set up on many trading platforms. The steps to place an order are as follows:
At this point, the order would be sent and likely filled.
A market order is a financial markets direction that instructs a brokerage to buy or sell a financial security at the best available price in the current financial market. A buy market order will purchase a security at the lowest available offer. A sell market order will sell a security at the highest available bid. As there is no requirement that the price of the security must meet, market orders should always be filled almost instantaneously.
A limit order is a financial markets direction that instructs a brokerage to buy or sell a financial security at a specified price or better. A buy limit order will purchase a security at the specified price or lower. A sell limit order will sell a security at the specified price or higher. These orders will only be executed if the price meets the order qualifications, so it is not guaranteed that such orders will be filled. Most professional traders use limit orders most of the time.
A stop order is a financial markets direction that becomes active once a specified pre-set price level is breached. A buy stop order will instruct a brokerage to purchase a security once the security has traded at the specified price or higher. A sell stop order will instruct a brokerage to sell the security once the security has traded at the specified price or lower. A stop order can be immediately marketable, similar to a market order, or have a limit with respect to how far beyond the specified price the trader is willing to transact at, similar to a limit order.
A trade through key is a hotkey that can typically be used with any electronic communication network. It allows a trader to set an amount or percentage by which they are willing to buy above the ask or sell below the bid in order to get their order filled. This function can be used on both the buy side and the sell side.
If a trader is long 500 shares of stock “A” and the market begins to turn quickly, so the trader wants to exit their position quickly, they could do so using a trade through key. If the bid is $150.61 and the trade through key is set to $0.10, the order would be filled down to a price of $150.51, if there is enough liquidity. In this example, the order would fill 400 shares at $150.61 and 100 shares at $150.60.
A hotkey can be created to either enter a limit order at whatever price the bid currently is or to enter a market order.
Electronic communications network specific keys can be created for various trading needs depending on your trading style and the ECNs available through your broker.
If trading in a stock should be halted, it would require a hotkey specific to the primary exchange that the stock trades on in order to trade that stock as it emerges from the halt.
These allow a trader to place an on-open or an on-close order to ensure that the trader receives either the first or final print of the day.
A TWAP order is a time-weighted average price order, while a VWAP order is a volume-weighted average price order. This order type allows a trader to get out of a position within the parameters of these orders.
These types of orders are somewhat complicated and not all traders have access to them or the data necessary to use them effectively. However, they are, in essence, used to buy or sell on the open of the market and the close of the market.
A “midpoint order” is an order that is sent out to the midpoint of the bid-ask spread. Traders will often, but not always, get filled at a price between the best bid and offer price. This strategy seeks price improvement by obtaining a more favorable rate than simply buying at the National Best Bid and Offer price.
“A derivative is a bet on whether a stock, or a bond or a real estate asset, is going to go up or down. There's a winner and a loser. It's like betting on a horse race.”
— Michael Hudson, economist
While there were a myriad of types of option derivatives introduced in the third chapter of this course, the focus of this chapter will be far more narrow. This is because there are only two types of options that are particularly relevant to the vast majority of traders and investors. These are vanilla calls and vanilla puts. Most of the exotic options introduced in the third chapter are typically only available to institutional traders.
Vanilla calls and vanilla puts, or, more specifically, American style calls and puts, typically trade on the Chicago Board Options Exchange (Cboe). There are substantial and highly liquid markets for these instruments, enabling traders and investors of all stripes to easily utilize them in their strategies. However, before options can be utilized within a strategy, the procedural incidentals for trading options must be established. This chapter will discuss the mechanics of options: their availability, their functionality, their pricing, and how to place an order to buy or sell an option or an options spread.
In order to trade calls and puts, a trader or investor must know what calls and puts are available to trade. Not every equity or exchange traded fund will have options that expire on the same dates or have the same strike prices. Some do not have any option contracts associated with them at all. To find out what calls and puts are available to trade, one must view an options chain.
An options chain is a list of all available call contracts and put contracts available for a specific security. They are organized first by date of expiration and then by strike price. For each contract an options chain will typically display the bid price, the ask price, the last traded price, the volume traded for the current or most recent market session, and the open interest.
Most brokerages in the United States should provide options chains for all securities for which the Chicago Board Options Exchange provides quotes. Securities that have a high trading volume or have derivatives that have a high trading volume will typically get more expiration dates and more strike prices.
Due to extremely high demand and tremendous volume for contracts for certain exchange traded funds that track prominent indices, these securities have options chains with expiration dates on every Monday, Wednesday, and Friday – and in recent years, contracts that expire every session.
Many brokerages and trading platforms will offer information in their options chains, or elsewhere, about an options contract beyond its bid price and ask price. They will include the factors that contribute to the determination of a bid price and ask price. These contributing factors are commonly known as the “Greeks”. The Greeks are an assessment of risk in an option or an options position. They measure the sensitivity of the price of an option, both to its underlying and to a multitude of other determining parameters.
While there are over a dozen Greeks, when traders and investors mention the Greeks they are typically referring to five of them: delta, gamma, theta, vega, and rho. The remaining Greeks are derivatives of these five Greeks or a derivative of a different Greek that is itself a derivative.
The significance of the Greeks and their effects on the prices of options was codified in 1973 by the financial economists Fischer Black and Myron Scholes. In their seminal article “The Pricing of Options and Corporate Liabilities” in the Journal of Political Economy, they introduced what would later be termed the “Black-Scholes options pricing model”. This is a multivariate function that yields an estimate for the price of European-style options. It shows that options have a unique price tied to the risk of the derivative and its expected return. In this context, the Greeks represent the sensitivity of this partial differential equation to changes in its parameters.
First order Greeks are the Greeks that are not a derivative of any other Greek. Rather, they are the Greeks that all of the other Greeks are derived from. They are the sensitivities to different factors of the price of an option and they play an important role in the Black-Scholes model.
Second order Greeks are the Greeks that are derived directly from the first order Greeks. While first order Greeks are the sensitivities to different factors of the price of an option, second order Greeks are the sensitivities of first order Greeks to shifts in various factors. With the exception of gamma, they are much less commonly considered by traders and investors than the first order Greeks.
Third order Greeks are Greeks that are derived from the second order Greeks. They measure the sensitivity of the second order Greeks to shifts in various factors. While quantitative analysts might occasionally utilize them, there are no third order Greeks that are commonly considered by most traders or investors.
In the realm of vanilla options, call contracts give their owner the right to purchase the underlying asset at the specified strike price by a certain date, while put contracts give their owner the right to sell the underlying asset at the specified strike price by a certain date.
For European options, the right to buy or sell the underlying asset can only be exercised at the moment of expiration. For American options, however, the right to buy or sell the underlying asset can be exercised at any point up to the moment of expiration. Most options with equities and exchange traded products as their underlying assets are American options, while most options with an index serving as the underlying, and are thus cash-settled, are European options.
If the holder of an option contract exercises their right, a party that is short the contract will be obligated to fulfill the other side of this agreement. The assignment of options obligations is determined by the clearinghouse of the Chicago Mercantile Exchange, CME Clearing. This organization uses an algorithm to randomize the process of allocating assignment.
If an option expires in the money, the options are automatically exercised, unless otherwise instructed, and assignment and delivery of the shares would occur in the pre-market of the next market session. Option holders typically have until 5:30 PM EST on the day of expiration to exercise a contract, even if it expired out of the money.
There are a large number of brokerages that offer options trading services. Almost all of the dozen or so online brokerages that are popular in the United States provide a platform with options trading capabilities. The Chicago Board Options Exchange even offers their own trading platform called Silexx. This chapter will show how to put in an order for an equity option on the platform of one of the largest and most popular brokerages in the United States, Charles Schwab.
At this point, the order would be sent and likely filled.
While buying or selling a single put or call is certainly a common method for trading options, there are dozens of options trading strategies available that both professional money managers and retail traders use regularly. These strategies can be used to limit risk, construct a payoff structure, or yield a specific degree of directional exposure to the underlying asset. Options spreads must be utilized in order to achieve this level of precision.
This example will show how to put in an order for an equity options spread on the Charles Schwab brokerage platform:
At this point, the order would be sent and likely filled.